Rumours of potential reform to pension tax policy have begun to swirl following Chancellor, Rachel Reeves’, speech yesterday (29 July), in which she highlighted a ‘£20bn black hole’ in public finances that needs to be plugged.

There are several avenues that Reeves may choose to address the funding shortfall, including pension tax.

As AJ Bell director of public policy, Tom Selby, pointed out, “pretty much every major fiscal event over the last two decades have been preceded by feverish speculation that the axe could fall on pension tax perks”.

“There are broadly three different avenues the chancellor could pursue if she wanted to raise cash from savers – but each comes with significant practical and political challenges,” he noted.

One of these could be to restrict people’s entitlement to take tax-free cash when they access their pension, with most being able to take 25 per cent of their pot from age 55 without paying any tax on it.

However, Selby warned that this would be deeply unpopular and fundamentally undermine the wider government aim of boosting long-term investment, including in UK plc.

“It would also inevitably be hugely complicated, as those who have already built-up entitlements to tax-free cash under the existing rules would almost certainly need to be protected against a retrospective retirement tax,” he continued.

“Furthermore, the overall amount people can access tax-free has already been scaled back significantly over the last 14 years, and if the current figure remains frozen, it will continue to be eroded in real terms.”

Evelyn Partners financial planning partner, Gary Smith, added: “Labour and certain think-tanks have also long been sceptical of the virtues of the 2015 pension freedoms, which revolutionised the rules around accessing and using pension savings.

“The main bugbear seems to be the 25 [per cent] tax-free lump sum, which the IFS reckons comes at a cost of £5.5bn.

“This popular benefit is capped at £268,275 thanks to the new Lump Sum Allowance and an attempt to restrict it further would come in for some criticism as the government would be accused of moving the goalposts again on pensions.”

Another potential option for Reeves, which Selby described as the most common speculation, was the future of higher-rate pension tax relief and the potential to introduce a flat rate of pension tax relief.

Hargeaves Lansdown head of retirement analysis, Helen Morrissey, commented: "Rumours are already swirling that the Chancellor could turn to pensions as she seeks to fill the black hole in the nation’s finances.

“Introducing flat rate tax relief is one such story, as well as predictions that she could look to trim back tax-free cash. Making pensions liable for inheritance tax is another way she could look to raise money, as this tax treatment looks generous when compared to other wrappers such as ISAs.

“Whether such changes will come to pass remains subject to debate but any changes to pension tax need to be part of a wider ranging review. Years of tinkering around the edges has resulted in a complicated system that can undermine people’s confidence in pensions.

“An overarching review should look at how the system can be made simpler for people to navigate and help them to plan for the future without fear of major changes to how their savings will be treated.”

Aegon pensions director, Steven Cameron, said that while potential plans to move to a flat rate of pensions tax relief could be argued as fair, it also has its flaws.

“A flat rate of relief of say 30 per cent would be good news for basic rate taxpayers,” he continued.

“Currently, every personal contribution of £80 they make receives a £20 tax relief top-up. Under a 30 per cent rate of relief, this would be increased to £34.28 – an extra £14.28 - which over time and with compound investment growth will provide a more generous pot at retirement.

“But this would be at the expense of higher and additional rate taxpayers who would get a less generous top-up. A higher rate taxpayer paying in £80 would also see this topped up by £34.28, less generous than the current top-up of £53.33.

“Higher rate taxpayers could face a double whammy as it’s likely they’d also be required to pay income tax on employer pension contributions. This would be needed to stop employees ‘doing a deal’ with their employer to sacrifice some of their salary in return for a higher employer pension contribution. This could mean employees paying tax of 10 per cent of employer contributions, a further £10 hit for every £100 paid by their employer.

“In some schemes, employers pay very substantial contributions. In some public sector defined benefit pensions, employer contributions can be worth 20 per cent or more of pay. Here, an individual earning £60,000 might be benefitting from an employer contribution of £12,000 a year and could be landed with a tax bill of £1,200.

“We’ve already seen the pensions tax system discouraging higher paid professionals in the NHS from remaining in work, and this could have a similar effect.”

The final avenue of speculation was on the tax treatment of pensions on death, which Selby said would be viewed by many as “low-hanging tax fruit ready to be picked”.

He stated: “Under existing rules, it is possible to pass on your retirement pot completely tax-free to your nominated beneficiaries if you die before age 75.

“If you die after age 75, any inherited pension is taxed in the same way as income.

"Crucially, pensions usually don’t form part of people’s estate for inheritance tax (IHT) purposes.

“This is undoubtedly a generous set of rules and something which could easily be reviewed by the new government. However, as is often the case with pensions, applying any new tax on death – or bringing pensions into the IHT net – would come with substantial challenges.

“The biggest of those would be around how to treat people who have made decisions about their retirement pot based on the pensions death tax rules as they are today. There will, for example, be lots of people who chose to transfer defined benefit pensions into a defined contribution scheme in part because they wanted to prioritise passing money on tax efficiently to loved ones.

“If all of a sudden that money became subject to a new pensions death tax, those people would, understandably, feel like the rug has been pulled from under them. It is therefore possible a complicated protection regime would be needed to ensure people are not subject to unfair and arguably retrospective tax measures.

“This would inevitably reduce the money the Treasury could potentially raise from such a move.”

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